Will Failure of the European Monetary Union Jeopardise the Successful Record of The

II

54

Economic Modernization Processes in Europe toward the Millennium: Successes and Failures

Kerekgyarto, D. Sc. Gyorgy

Will Failure of the "European Monetary Union" Jeopardise the Successful Record of the Single European Market?

Prof. Dr. Dr. John G. Milios

Department of Humanities, Social Sciences and Law,

National Technical University of Athens,

Pontou 26, 14563 Kifissia, Athens, GREECE

email:

Fax: ++30 1 7721 618, Tel: ++30 1 7721 611.

European Integration, European Single Market, Monetary Union

I hereby give permission to publish this paper in the proceedings of the 1996 ISSEI Conference

September 5, 1996

Introduction

With the foundation of the European Economic Community in 1958, the idea of an economic integration of the member-states on the basis of an Economic and Monetary Union was raised. This plan, though, was proved to be very contradictory:

One of its axes, the goal of fixed nominal exchange rates, led to the distortion of the competitive position of virtually every national economy involved. These distortions (overvaluations or devaluations in real-terms of national currencies and consequent trade-balance deficits or surpluses) manifest themselves in the periodically occurring monetary crises, which lead to revisions of the Monetary Union plans.

Its other axis, the goal of unification of European markets through the abolition not only of tariffs, but also of all non-tariff barriers in commodity (goods and services) and capital markets was proved to be much more successful in promoting technological innovation, increasing the international competitiveness of EU-countries, etc.

The question raised is what factors determine the persistence of member-states and EU authorities in pursuing the Monetary Union plan, and to what extent this plan may retard or jeopardise the so far successful record of the unified European markets.

1.   Successes and Failures: The Single Market and the Monetary Union

The process of economic integration of Western Europe, which was initiated with the foundation of the European Economic Community in 1958, has developed successfully in its major axes. The Customs Union (CU) for commercial goods of the initially six member-states (Belgium, France, F.R. Germany, Italy, Luxembourg, The Netherlands) was realised in the 1960s earlier than planned, a common market for agricultural products was also created, the number of EC member-states was increased to 9 in 1973 (Denmark, Ireland, UK), 10 in 1981 (Greece), 12 in 1986 (Portugal, Spain) and 15 in 1995 (Austria, Finland, Sweden). In the early 1970s, the guidelines for a European Political Co-operation (EPC) were also formulated.

In 1986, the adoption of the Single European Act (SEA) gave a new impetus to European integration, by putting forward a process of gradual creation of a “European Single Market” (ESM) until the end of 1992, i.e. by removing EC cross-frontier goods traffic controls, unifying national production standards, abolishing all tax differences, creating common markets for services, allowing access of all European companies to government orders (especially in concern with telecommunications, transportation and energy), and by unifying the European financial markets through relaxation of national capital movements’ controls (1), (2).

In February 1992, the Treaty on European Union, signed in Maastricht, established new forms of policies in three directions: a) An increase (albeit limited) in the role and the responsibilities of the European Parliament, b) the transformation of EPC to a Common Foreign and Security Policy, which may “include a common defence policy, which might in time lead to a common defence” (Article J.4), and c) the formulation of economic “converge criteria”, which, when met by EU member-states, will allow them to proceed to the third and final stage of a Monetary Union (MU) and to launch a single currency on January 1, 1999.

The Maastricht criteria on MU are: low inflation and interest rates, exchange rate stability, as well as public deficits and government debt no higher than 3 per cent and 60 per cent of gross domestic product respectively. The Maastricht treaty offers the chance for a fast-track MU in 1997 if a majority of member states meet the criteria in 1996. (3) Although the European Commission tried to keep alive hopes of an early launch date, it has long been apparent that 1997 is not feasible, since only Germany, France and Luxembourg would be in a position to fulfil the criteria by the end of 1996. In January 1996 EU leaders quietly abandoned the early launch date and set all hopes on 1999, when a majority is no longer needed. (4)
The effect of the CU and of ESM on the process of European integration, was proved to be very positive, by backing foreign trade and capital movements. In the time period 1958-72 the intra-EC trade increased from nearly 30% to more than 50% of the total international trade of the six member states, boosting the EC-6 share in the world trade from 21.9% to 29.8%. In the same time period the international trade share of the USA was reduced from 16.3% to 11.7% (1). A deterioration of the Community’s international competitive position took place, however, in the mid-1980s, leading in the time period 1985-88, to a stagnating intra-EC trade share (approx. 52% of the total EC trade), a decreasing intra-EC trade as a percent to EC output (15.1% in 1985, 14.3% in 1988), and a stagnating EC share in the total world trade (approx. 32% in 1985-88, 33% in 1980). (5) Nevertheless, as a result of the ESM program and the expansion of the Community, the intra-EU trade as a share of total imports and exports of the EC-12 has risen since 1988, to exceed 61% in 1992 (6), and the EC-12 share in the total world trade increased to 36.3% in 1992 (and 36.9 in 1995). Only the Intra-EC trade as a percent to EC output did not recover on a stable basis: 15.1% in 1989, 14.1 in 1991, 13.1 in 1993. (7)

Contrary to the successes of the CU and the ESM, all attempts to create a European Monetary Union (MU) have failed. The perspective of a MU was for the first time formulated in December 1969, by European Prime Ministers meeting in Den Haag. The “Werner plan”, which was approved by the Council of Ministers in 1971, claimed that the irreversible fixing of exchange rates, the establishment of a common European central bank and of a supra-national economic policy decision centre would have been created until 1980. This plan soon collapsed, though, as the international economic crisis of 1971-73 and the subsequent high (although unequal) inflation rates resulted in an acute monetary turmoil and the abandoning of the Bretton Woods fixed exchange rate system of the international economy. The EC countries sustained, however, the strategy of a MU, and in March 1973 they fixed the margin of fluctuation among EC currencies at 2.25%. Until 1978 the British, French, Italian, Irish and the associated Norwegian and Swedish currencies had left the system, which means that the MU plan had failed. (8)

Despite these failures, the European Council decided in December 1978 to establish a European Monetary System (EMS), by introducing: 1. a European Currency Unit (ECU), which played the role of a numeraire to fix the central rates of European currencies and of a unit of account in the intervention and the credit mechanisms; 2. an Exchange Rate Mechanism (ERM), which allowed a margin of fluctuation of each EC currency of + 2.25% in respect to the central rate, for all currencies, except of the Italian (initially) and the Spanish, British and Portuguese (after their entrance in the ERM) currencies, which were given a fluctuation margin of + 6%; 3. a plan for establishing a European Monetary Fund (EMF), which would control the credit mechanisms of the EMS. The EMS was much more flexible than the previous plans of monetary integration. In the time period 1979-87 it allowed 11 readjustments of exchange rates between European currencies. (8) It is not by chance then, that it lasted more time than any previous plan of MU.

The relative stability of the EMS in the 1980s encouraged EC Prime Ministers and heads of state, meeting in June 1989 in Madrid, to re-accelerate the MU process on the basis of the “Delors Report”. The Maastricht Treaty and the criteria on MU was a next logical step. However, fixing nominal exchange rates may very well mean increasing deviation of real exchange rates, in case of countries with different inflation rates, economic structures and competitive positions. So “between 1979 and 1992, but especially from 1987 to 1992, the DM was undervalued in real terms in the EMS. In this way, Germany experienced artificial advantages regarding price competition, which was reflected clearly in the trade balances” (9). At the same time, Germany’s high interest rates (6.75% in 1992), due to the high cost of the country’s re-unification, had to be adopted by its EU competitors, in their effort to keep nominal exchange rates fixed. Moreover, the increasing French trade deficit resulted in interest rates higher than 8%, despite the country’s low inflation rate (2% vs. approx. 4% in Germany), in order to achieve high capital imports. The French economy (like the Spanish, the Italian …) was caught in a vicious cycle of trade deficits - high interest rates - depression. The only way out of the vicious cycle was the way out of ERM. The first crisis in September 1992 and the second one in August 1993 practically annulled the ERM.

2. Anti-inflation Policy and Optimum Currency Areas

The 1993 crisis resulted in adopting new, large, margins of fluctuation of EC currencies participating in the ERM (+ 15%). However, the EU countries did not give up their strategy to create a MU before the end of the century. The main argument behind all MU plans was, traditionally, disinflation: The EMS functions as a system providing credibility and discipline to high-inflation countries, so that they undertake a successful programme of disinflation. These countries passively peg their exchange rate to the DM, then the low inflation propensity in Germany should shift downwards inflation expectations in the other countries.

After the implementation of the ESM plan, the MU is considered as the necessary consequence (or sometimes as presupposition) of the single market. This approach is directly related to the theory of Optimum Currency Areas (OCA). An Optimum Currency Area is a domain with fully flexible wages and prices, or alternatively with high mobility of factors of production, namely labour and capital. A currency area is optimal if participation does not raise a member's need to use its fiscal policy for domestic stabilisation, or if it does not raise its vulnerability to real shocks. It is to the benefit of individual countries to shape a common currency area in case they have high volumes of trade exchanges among them, or if they are much dependent on trade.

A considerable number of analyses (10) show, however, that the EU cannot be considered as an OCA:

* There are differences in structures of production among European member-states and sharp differences in demand (and supply) shocks affecting the countries of the so-called “core Europe” (Benelux, Denmark, France, Germany) and the “peripheral states” (Greece, Italy, Ireland, Portugal, Spain and the UK).

* The labour mobility in the EU is very limited. Cross-border residence of EU citizens was only 1.4% of EU total population, while that of non-EU workers (mainly Turks) was 2.4%.

* As already argued, despite the fact that intra-EU trade as a share of total trade of individual countries exceeds 60%, EU trade dependence (intra-EU trade as a percentage of GDP), is low and so the exchange rate policy instrument remains important for the majority of member-states.

* Last but not least, it is doubtful if an OCA can exist without a dominant economic and political power.

Disputable is also the disinflation argument. Against all expectations of mainstream economics, Italian, Spanish, Portuguese and UK inflation continued to fall after departure from the European exchange rate mechanism in September 1992. In addition, there have been no adverse inflationary consequences from monetary growth above the suggested monitoring ranges.

The inflation level in a country, (as well as the divergence in inflation rates among different countries) depends, to a large extent, on the structural differences among sectors of the economy (or among single economies) and is not a mere outcome of monetary policy. Cost increases (resulting in profit squeezes) in less developed sectors of a national economy, when combined with oligopolistic market structures, entail price increases: the reason is that the less productive enterprises cannot cope with profit reductions mainly through productivity increases, but consider price increases (or labour cost reductions) as the only way out of the “crisis”. This structural component and not monetary policy mainly explains the behaviour of inflation. (11)

The MU could have a chance to be successful, only if it were embedded in a real federal fiscal and social policy. This is, though not the case of the EU: EU budget represents only 1.27% of the EU GDP, while 0.75% of this 1.27% goes to the Common Agricultural Policy.

3. Planning the Future Monetary Union: A Policy of the Present

The EU is not an OCA and it is certain that not all countries in Europe will profit from a MU. Tight monetary policies have also been to a large extent responsible for the high unemployment and lack of growth in Europe. This is particularly severe for the smaller countries of the EU (12). The question is then, why do all countries support the MU plan.

Conservative Politicians, who oppose the process of European integration from a nationalist point of view, often reply to this question by referring to conspiracies of anti-national groups or bureaucrats. So Connoly, the British former head of the Commission division during the Thatcher era, considers the ERM as “part of a programme to subvert the independence of Europe’s countries”, and he adds: “for many left-wing, middle-class Britons, ‘Europe’ exercises a grip on the imagination similar to that of the Soviet Union on the Philby generation at Cambridge in the 1930s” (13).